Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Monday, April 16, 2012

I have been on something of a blog vacation (and about time, you might say), though I can assure you there has been nothing relaxing about it. I was reading Laurence Ball's paper on "Ben Bernanke and the Zero Bound, I think that it raises some interesting questions, and I would like to relate this to current thinking (and current thinkers) on the FOMC.

Ball wants to have us think that the pre-2003 Ben Bernanke was a sensible person who argued that, in the context of the zero lower bound on the overnight nominal interest rate, a central bank is not powerless. According to Ball, pre-2003 Bernanke thought, first, that forward guidance (announcements about future monetary policy actions) and quantitative easing (large-scale asset purchases) at the zero bound are a good idea. Those policy options are indeed reflected in post-financial crisis monetary policy in the United States. Second, and more importantly, Ball argues that pre-2003 Bernanke advocated another set of zero-bound accommodative policies, which are:(i) exchange rate depreciation(ii) targets for long-term nominal interest rates(iii) money-financed tax cuts(iv) higher inflation targets

Ball is bothered by the fact that such policies have not been pursued by the current incarnation of the FOMC, as he appears to think that those policies would be appropriate at the current time. Ball has little to say - explicitly - about the science of monetary policy. He's thinking about a model of Ben Bernanke, not a macroeconomic model designed to evaluate and guide monetary policymakers.

Ball's premise is that pre-2003 Bernanke was right, and post-2003 Bernanke was wrong. What could have made Ben do such stupid things? Did he fall and hit his head? Not at all. The answer is "groupthink," and what Ball calls "personality." You have all probably heard about groupthink, which has entered the realm of pop psychology. The idea seems to be that a group may not be greater than the sum of its parts. Group members may interact in a way that produces bad results, if an urge to cooperate and forge consensus overwhelms good ideas. There's a long Wikipedia entry where you can read all about it. On the personality front, Ball characterizes Bernanke as "shy," and provides plenty of supporting evidence.

Actually, the general thrust of the paper can be summarized by: "Ben Bernanke is a wimp." I may be wrong, but I don't think he is. Economists are tough. We cannot survive as academics without being willing to defend our ideas. Bernanke flourished as an academic, and worked at Princeton, which of course is no slouch institution. He survived a period as department chair there, a position in which I'm sure he developed considerable skills in forging consensus. There is nothing wrong with consensus. Many healthy decision-making bodies thrive on it.

The key question, which I'm sure you are asking, is: What do we think of those zero bound accommodative policies - (i) through (iv) above - anyway? First, it's important to understand that a Central Bank is just that. It is a special kind of bank - a financial intermediary with some unique powers. In the United States, the unique powers of the Fed are its ability to issue currency (actually an implicit special power, but I don't want to elaborate on that here) and its ability to issue reserves which are used in intraday payments and settlement. Unless the Fed is exploiting those special powers, it really cannot influence anything.

What can the Fed do under current circumstances? It can change the interest rate on reserves (IROR). That's a decision that can only be made by the Board of Governors - not the FOMC. We're currently operating under a floor system (for a brief rundown read this post by Todd Keister) under which, roughly, the interest rate on reserves governs the behavior of the fed funds rate, with some slippage due to the idiosyncrasies of the US financial institutional setup. The Fed can also buy and sell assets - quantitative easing (QE). Finally, the Fed can resort to forward guidance - it can tell us about its intentions for future policy.

Everyone agrees, I think, that changing the IROR matters in the current context. Not everyone agrees that QE does what the Fed thinks it does. My view is, that with a large stock of excess reserves outstanding overnight, QE is irrelevant. Basically, that's a neutrality theorem. Under current circumstances, the Fed has no advantage over the private sector in turning long-maturity assets (Treasury bonds or mortgage-backed securities, for example) into overnight assets, so QE cannot matter. To my knowledge, no FOMC member agrees with me, and blog commenters tend to call me an idiot whenever I mention this. Watch.

Finally, what about forward guidance? When the Fed first "committed" to its forward guidance policy in August 2011, I stated that I thought this was bad commitment, and would create more confusion rather than less. That initial forward guidance policy has since been extended, and now reads like this:

...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

But, the minutes of the March 13 meeting state:

It was noted that the Committee's forward guidance is conditional on economic developments, and members concurred that the date given in the statement would be subject to revision in response to significant changes in the economic outlook. While recent employment data had been encouraging, a number of members perceived a nonnegligible risk that improvements in employment could diminish as the year progressed, as had occurred in 2010 and 2011, and saw this risk as reinforcing the case for leaving the forward guidance unchanged at this meeting. In contrast, one member judged that maintaining the current degree of policy accommodation much beyond this year would likely be inappropriate; that member anticipated that a tightening of monetary policy would be necessary well before the end of 2014 in order to keep inflation close to the Committee's 2 percent objective.

So what are we to make of that? Does the forward guidance mean anything at all? I don't know about you, but I'm confused.

So, what of policies (i)-(iv) above? First, exchange rate depreciaton and higher inflation targets are not explicit policies. Exchange rate deprecation and higher inflation can be the result of policy actions by the Fed, but we can't just wish for these things and expect them to happen. Indeed, under current circumstances, the Fed simply cannot engineer a currency depreciation, or a a higher inflation rate, on its own. The IROR is not going lower. Ben Bernanke himself has stated that there are technical reasons why the IROR cannot go below 0.25%, and we're not going to get much from a quarter-point reduction anyway. Further, as I stated, asset purchases are irrelevant under current circumstances. Finally, there is enough noise in the forward guidance signal now to make that signal uninformative. Thus, exchange rate depreciaton and higher inflation are not happening, at least as the result of anything the Fed does currently.

What about targets for long-term nominal interest rates? Not happening. The Fed should not be setting a target for something it cannot control. What about money-financed tax policy? Not happening. That's the province of the Congress. Maybe you think Ben Bernanke can influence those crackpots, but you're wishing for a lot in that case.

So much for Ball's paper. But here's something interesting, which is related. Read this speech by Narayana Kocherlakota, President of the Minneapolis Fed. Speaking of turnarounds in thinking, I would not have predicted a few years ago that stuff like this would come out of Narayana's mouth.

What's Kocherlakota's view of policy under the current circumstances? He thinks that changes in the IROR matter, he thinks QE matters, and he thinks forward guidance matters. What's the model that helps him think about how to formulate policy? It seems to be some some kind of 1974-ish expectations-augmented Phillips curve. The inflation rate is determined by the output gap and the anticipated rate of inflation, and the anticipated rate of inflation in turn seems to be determined (in Kocherlakota's mind) by what the Fed says. What does the Fed care about? The output gap and the inflation rate. As is usual given this type of thinking, the idea is that we can get more output if we are willing to sacrifice by accepting a higher inflation rate.

What's wrong with that view of the world? (i) Where's the money? Inflation is always and everywhere a monetary phenomenon. Milton Friedman's quantity-theory view of the world was in several ways wrongheaded, but we can't escape the idea that the prices of goods and services are in fact the prices at which particular liabilities (public and private) are exchanged for those goods and services. The quantities of the particular liabilities in question have to be important for determining the prices. (ii) Phillips curve thinking got us into trouble before - in the 1970s - and it can do so again. (iii) If people on the FOMC think that QE and forward guidance work, those things should be in the model, so we can understand exactly how these things are supposed to work, and can evaluate the Fed's policy actions accordingly.

It's quite possible that Kocherlakota does not even believe in the model in the speech I linked to above, or in the model in this talk, for that matter. Here's a possible explanation for what is going on. Kocherlakota may think that if he stuck to what he actually knows about modern monetary economics - which is a lot - in framing arguments at FOMC meetings, that the other participants would not get it. After all, even some of the more sophisticated economists on the FOMC - John Williams and Charles Evans, for example - are Phillips curve guys. But maybe those people can be educated. I think it's worth a shot.

I think that Kocherlakota basically arrives at the correct conclusion about Fed policy here:

I would say that it would be appropriate to change the Fed’s current forward guidance to the public about the future course of interest rates. Currently, the FOMC statement reads that the Committee believes that conditions will warrant extraordinarily low interest rates through late 2014. My own belief is that we will need to initiate our somewhat lengthy exit strategy sometime in the next six to nine months or so, and that conditions will warrant raising rates sometime in 2013 or, possibly, late 2012.

It's the right conclusion, but it's actually inconsistent with what he's said in the rest of the speech. If he thinks that QE works, he should just want to do everything in reverse - sell the assets until excess reserves are down to zero, then start increasing the fed funds target, which will at that point in time be the policy rate. Some people on the FOMC might think this policy - reverse QE followed by increases in the target policy rate - would in fact be appropriate. What they need to understand is that QE doesn't work right now, and bad things can happen while they are learning by doing.